Key Takeaways
Carry trades are about taking advantage of the difference in interest rates between two currencies or financial instruments.
The idea is to borrow in a currency with a low interest rate and invest in one with a higher rate. If exchange rates behave, you earn what's called the "carry" (i.e., profit from the rate difference).
While carry trades can be profitable, unexpected shifts in currency values or interest rates can quickly turn a good trade into a bad one. The 2008 financial crisis and the 2024 changes in Japan's monetary policy are examples of how these trades can go wrong.
Carry trades often require a solid understanding of global markets, central bank decisions, and how to manage leverage effectively. As such, they are more suitable for experienced investors or big institutions.
What Is a Carry Trade?
A carry trade is a strategy where you borrow money in a currency with low interest rates and invest it in a different currency or asset that offers higher returns. The idea is simple: you're looking to profit from the difference between these rates.
While this strategy is mostly used in the world of forex and currency trading, it can also be applied to stocks, bonds, and even commodities.
How Carry Trades Work
Here’s how it usually goes: you take out a loan in a currency that has low or near-zero interest rates – think the Japanese yen (JPY), which has had low rates for years. Then, you convert that money into a currency with a higher interest rate, like the US dollar. Once you have the higher-yielding currency, you invest it in something like US government bonds or other assets that give you a good return.
For example, if you borrow yen at 0% and invest it in something that pays 5.5%, you're earning that 5.5%, minus any fees or costs. It’s like turning cheap money into more money (as long as the exchange rates play nice).
Why Investors Use Carry Trades
Carry trades are popular because they offer a way to earn a steady return from the interest rate difference, without needing the value of the investment to go up. This makes it a favorite among big players like hedge funds and institutional investors, who have the tools and knowledge to manage the risks.
Often, investors use leverage in carry trades, which means they borrow a lot more money than they actually have. This can make the returns much bigger – but it also means the losses can be just as large if things don’t go as planned.
Examples of Carry Trades
One of the most well-known examples of a carry trade is the classic yen-dollar strategy. For years, investors borrowed Japanese yen and used that money to invest in US assets that offered much higher returns. This was a sweet deal as long as the difference in interest rates stayed favorable and the yen didn’t suddenly spike in value against the dollar – which eventually happened in July 2024 (more on this soon).
Another popular example involves emerging markets. Here, investors borrow in a low-interest currency and then invest in higher-yielding currencies or bonds from emerging markets. The potential returns can be great, but these trades are highly sensitive to global market conditions and shifts in investor sentiment. If things go bad, they can quickly turn from profitable to problematic.
Risks of Carry Trades
As with any investment strategy, carry trades aren’t without risks. The biggest one is currency risk. If the currency you borrowed suddenly becomes more valuable compared to the one you invested in, your profits can disappear or even turn into losses when you convert back.
For example, if you borrow JPY and buy USD, and the yen gets stronger against the dollar, you could lose money when you switch back to the yen. Interest rate changes are another risk. If the central bank of the currency you borrowed raises interest rates, your borrowing costs go up, which can eat into your profits. Or, if the bank of the currency you invested in cuts rates, your returns drop.
These risks became very real during the 2008 financial crisis, when many investors lost big on carry trades, especially those involving the yen. In 2024, changes in Japan’s monetary policy caused the yen to strengthen, leading to a wave of carry trade unwinding and market turbulence.
The Impact of Market Conditions
Carry trades tend to do better when the market is calm and optimistic. In these stable or bullish conditions, currencies and interest rates don’t move around too much, and investors are more willing to take on risk.
However, when the market gets shaky or there’s economic uncertainty, carry trades can become very risky, very fast. In highly leveraged and volatile markets, investors might panic and start unwinding their carry trades, which can cause big swings in currency prices and even lead to broader financial instability.
When the Bank of Japan unexpectedly raised interest rates in July 2024, the yen jumped in value, leading many investors to quickly unwind their yen carry trades. The result was a rush to sell higher-risk assets to repay yen loans, which didn’t just rattle currency markets but also sparked a global sell-off of riskier investments. The impact was further amplified by leveraged positions.
Closing Thoughts
Carry trades can be an interesting way to profit from differences in interest rates between currencies or assets. Still, it’s important to consider the risks, especially in highly leveraged and volatile markets.
To be successful with carry trades, you need a strong grasp of global markets, currency movements, and interest rate trends. Since these can turn on you if the market changes unexpectedly, carry trades are better suited for experienced investors or institutions with the resources to manage risks effectively.
Further Reading
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